The moving average is one of the most useful, objective and oldest analytical tools around. Some patterns and indicators can be somewhat subjective, where analysts may disagree on if the pattern is truly forming or if there is a deviation that is might be an illusion. The moving average is more of a cut-and-dry approach to analyzing stock charts and predicting performance, and it is one of the few that doesn’t require a genius intelligence to interpret..
Moving average is an indicator that shows the average value of a security’s price over a period of time.
To find the 50 day Simple Moving Average you would add up the closing prices (but not always more later) from the past 50 days and divide them by 50. And because prices are constantly changing it means the moving average will move as well.
Exponential Moving Average (EMA) – is calculated by applying a percentage of today’s closing price to yesterday’s moving average value. Use an exponential moving average to place more weight on recent prices. As expected, each new price has a greater impact on the EMA than it has on the SMA. And, each new price changes the moving average only once, not twice.
The most commonly used moving averages are the 15, 20, 30, 45, 50, 100, and 200 day averages. Each moving average provides a different interpretation on what the stock price will do. There really isn’t just one “right” time frame. Moving averages with different time spans each tell a different story. The shorter the time span, the more sensitive the moving average will be to price changes. The longer the time span, the less sensitive or the more smoothed the moving average will be. Moving averages are used to emphasize the direction of a trend and smooth out price and volume fluctuations or “noise” that can confuse interpretation.
Different investors use moving averages for different reasons. While some use it as their primary analytic tool others simply use the moving average as confidence builder to back their investment decisions. Here are two other strategies that people use moving averages for:
Filtering is used to increase your confidence about an indicator. There are no set rules or things to look out for when filtering, just whatever makes you confident enough to invest your money. For example you might want to wait until a security crosses through its moving average and is at least 10% above the average to make sure that it is a true crossover. Remember, setting the percentile too high could result in “missing the boat” and buying the stock at its peak.
Another filter is to wait a day or two after the security crosses over, this can be used to make sure that the rise in the security isn’t a fluke or unsustained. Again, the downside is if you wait too long then you could end up missing some big profits.
Using Crossovers isn’t quite as easy as filtering. There are several different types of crossover’s, but all of them involve two or more moving averages. In a double crossover you are looking for a situation where the shortest MA crosses through the longer one. This is almost always considered to be a buying signal since the longer average is somewhat of a support level for the stock price.
For extra insurance you can use a triple crossover, whereby the shortest moving average must pass through the two higher ones. This is considered to be an even stronger buying indicator.